Tim Geithner Still Doesn’t Understand Capital Requirements

Last week Alan Blinder pointed out that despite all the hoopla about higher capital requirements coming out of the Basel negotiations, when the final requirements kick in in 2018, banks will only be required to have a Tier 1 leverage ratio of 33:1.

Photo by: Pete Souza

Timothy Geithner

“Isn't that about what Lehman Brothers had?” Blinder asked.

That’s the kind of question that’s likely to make ordinary people scratch their heads. Certainly, in the run up to the financial crisis, these kind of eye-popping leverage ratios made lots of ordinary people—and some extra-ordinary people—do something more than scratch their heads—it convinced them to sell their shares of financial companies.

During the financial crisis, analysts such as Meredith Whitney were able to cause lots of trouble for financial firms by pointing out that regardless of whether this or that company was meeting regulatory capital requirements, many of them simply lacked sufficient capital to survive a crunch.

A gap had emerged between the kind of capital allegedly prudent regulators required and the kind of capital reality—and eventually investors and counter-parties—required.

David Leonhardt asked Tim Geithner about this during the Washington Ideas Festival that took place last week (hat tip: Felix Salmon).

Geithner gave the answer eerily similar to the we heard many times from frustrated banking executives—that what mattered was not the simplistic measure of equity to assets—that is, leverage—but something more complex called “risk-weighted assets.”

“What matters is capital against risk. The assets in an institution are not a good measure of risk. What this [Basel III] requires you to hold is 10% of risk-weighted assets. And that’s the right measure,” Geithner told the folks as the festival for Washington ideas. (You can watch Geithner's answer here at about the 18:30 mark.)

What Geithner was inelegantly avoiding explaining is that not all assets are created equal. Some assets are riskier than others. Banks should reserve more to cover risky loans than less risky loans. That’s certainly true. The tricky part comes in trying to translate this into a regulatory policy.

Regulators are not in a good position to measure risk. They are typically over-confident in their predictions about the future. After all, financial regulators tend to be people who are confident in the competence and intelligence of financial regulators.

What’s more, regulators are subject to political pressure that warps their views of risk. Under Basel’s risk weighting scheme, cash and highly rated government bonds, for instance, are given a risk-weighting of zero—which means that nothing needs to be set aside for sovereign debt defaults.

You might have noticed, recently, that the chance of sovereign debt defaults is likely to be greater than zero. But giving a zero-risk weight to government debt encourages banks to buy more of it. In effect, this is a subsidy for government borrowing.

This subsidy is hardly costless. Most obviously, it explains why so many banks are so dangerously exposed to the debt of Greece. Less obviously, but perhaps more perversely, it encourages banks to buy government debt when they find capital scarce or expensive.

A bank facing a shortfall of regulatory capital can convert other assets into Treasurys rather than shell out a huge premium to the likes of Warren Buffett. You may have noticed that many banks have recently preferred government bonds with de minimus yields to making loans to businesses.

One reason: this provides relief from capital requirements. So the zero risk weighting given to government debt is pro-cyclical, encouraging a flight to safety just when the economy is starved for credit.

Under the first set of Basel rules, mortgages were given a risk-weighting of 50%, which means that a banks only had to set aside half of their reserve requirement for mortgage bonds. This level of risk-weighting was not set after some deep consideration of the relative risks of mortgages to other loans.

In fact, the Federal Reserve initially wanted mortgages to bear a 100% risk weighting. It was set at 50% in the 1980's because the regulators of West Germany, who wanted to stimulate the local housing market and whose banks wanted to invest in mortgages globally, insisted upon it (Cold War nostalgia).

Under an amendment to Basel I enacted in 2001, triple-A and double-A rated mortgage-backed securities have only a 20% risk weighting. This meant that holding securitized mortgages gave banks a 60% regulatory capital relief over holding actual mortgages.

You might have noticed that we just went through a global economic crisis rooted in the fact that so many of our financial companies were over-exposed to mortgage backed securities. This was in large part the result of the regulatory capital relief that came from owning MBS.

The regulators view of risk was wrong—even highly rated mortgage bonds were far riskier than their risk weighting implied—which meant that the concentration of banking assets in MBS proved disastrous.

The very attempt of translating risk weighting into policy may be counter-productive. All such risk weighting loads the dice in favor of the regulators view of risk—encouraging a kind of concentration on asset classes that creates systemic risk. (Hat tip here goes to Jeffrey Friedman of Critical Review, whose work on this subject should be required reading for everyone.)

Without the privileged risk-weighting of MBS, banks would very likely have had portfolios less correlated with one another. The failure of one would not necessarily have implied the failure of others.

Geithner seems completely oblivious to the deeper problems of risk-weighting. In fact, toward the end of his remarks on the subjects he implies that banks will be safer because their internal measurements of risk will be strictly constrained by the views of regulators.

In other words, despite the likelihood that the regulatory view of risk caused our last financial crisis, Geithner is telling us to be reassured because the regulatory view of risk will continue to dominate.